Risk and Return

Concept
 Objective of investment: to maximize returns subject to constraint
of risk
 Realised return: historical, was actually earned on an investment
 Expected return: future; anticipated based on past historical data
and future growth estimation
 Required return: minimum expected rate of return required to
induce investment in that particular security, based on its risk
component
 Components: yield (current, periodic cash receipts like dividends,
interest); capital gain/loss (sale price less purchase price)
Measuring Rate of Return

 Generally speaking,
Return= addition of income/cash flows and
capital gain (loss) divided by purchase price
 Stock’s rate of return and Bond’s rate of
return: concept of face value in a bond and
periodicity of payment of interest
Probabilities and rate of return

 Probability: number that describes chances of

an event taking place
 Expected rate of return: weighted average
rate of return with probability of each rate of
return as the weight
Risk
 Defined as: chance that the actual outcome from an investment
will differ from the expected outcome ie. dispersion in the likely
outcomes, or variability of returns
 Measurement:
- width of the probability distribution
- range: highest minus lowest possible rate of return
- Variance: sum of squared deviation of each possible r from
expected r multiplied by its probability
- Standard Deviation: square root of variance
 Standard deviation considered the best measure of risk
Sources of Risk

 Interest rate risk: more for bondholders

 Market risk: external factors like war, depression,
political moves etc.
 Inflation risk: affects purchasing power
 Business risk: peculiar to a particular industry/
market segment
 Financial risk: due to debt exposure in the company
 Liquidity risk: ability to trade a security in the
secondary market
Portfolios and Risk
 Investment Portfolio: group of assets owned by an investor , like
shares, debentures, bullion, real estate, bank’s FDs etc.
 Diversification: invest in assets such that risk of the portfolio is
less than sum of risks of individual assets in the portfolio
 Variables/factors may affect different returns on various assets in
different ways, positive or negative, and in different amounts/
proportions
 Perfectly negative or positive correlation amongst securities
difficult in practice
Diversifiable and Non diversifiable risk
Diversifiable risk
 Part of total risk which is
specific to functioning of
company/ industry
 Examples: company strike,
death of key management
personnel, entry of more
competitors, increased prices
of raw materials …..
 Can be eliminated by
diversification
 Also called unsystematic risk
or specific risk
Non diversifiable risk
 Part of total risk related to
general economy or stock
market as a whole
 Examples: change in tax
rates, natural calamities,
change in inflation rates,
change in economic policy,
recession…..
 Cannot be eliminated by
diversification
 Also called systematic risk
or market risk
Risk of stocks in a Portfolio
 Market portfolio: most diversified portfolio that an investor could buy
 Beta Coefficient of a security: measures its non diversifiable risk relative
to that of the market portfolio
 Measure of risk that it adds to the portfolio, since diversifiable risk can
always be eliminated through diversification, hence balance is the non
diversifiable risk
 Since risk is basically variability of returns, beta measures
responsiveness of returns or how much the return of the security would
vary with change in return on the market portfolio
 Beta of:
 one= average risk
 beta>1 asset whose return is more risky than the market
 beta<1 asset less risky than the market portfolio
Measurement of Beta (Single Index
Model)
 Relationship between return on security and return on the market
is a linear equation
 Beta is the slope of this regression relationship
 Beta measured as ratio of security’s covariance of return with the
market to the variance of the market
 Alpha parameter is intercept of the fitted line, measures return of
the security when market return is zero, can be plus or minus
 Characteristic Regression Line (CRL): Graphic representation of
this model, with market return on X axis and Return on security
on Y axis
Capital Asset Pricing Model (CAPM)

 Establishes linear relationship between required rate

of return of a security and its beta (systematic risk)
 Explains how trade-offs between risk and return are
determined in financial markets
 Required rate of return = risk free rate + risk
premium
 Risk premium = beta*(market return-risk free return),
since investors expect higher risk premium for riskier
assets
Capital Asset Pricing Model (CAPM)
 Security Market line: graphical representation of CAPM; plots
relationship between required rate of return of a security and its
beta coefficient
 When beta is 1, reqd. return on security = market return
 When beta is 0, reqd, return on security = risk free return, hence
SML intersects vertical axis at risk free return
 Slope of SML is market return minus risk free return
 SML used to classify securities: securities<1 beta, defensive
securities earning below average returns; with beta>1, are
aggressive securities
Capital Asset Pricing Model (CAPM)
 All securities expected to plot along the SML, hence can determine their
return rate given the beta
 Market said to be in equilibrium when expected return = required return
 Any other position creates forces that change its market price which
pushes the return on the SML
 If expected return >required return, security is underpriced, i.e time to
buy, hence more demand for it leads to increase in its MP leading to
decline in its expected return till it equates with the required return
 If expected return <required return, security is overpriced, i.e. time to
sell, hence selling pressure on it leads to decline in its MP thus leading
to increase in its expected return till it equates with the required return